Deep dollar market off limits amid euro crisis

The dollar market is the biggest, deepest and most liquid capital market in the world. Unfortunately, most European sovereigns are too scared to use it, for fear of being accused of betraying the euro at a time of extreme volatility and execution risk.
Philip Moore reports.

How much does 25m buy you? It might buy you a tenth of a new hospital. It would just cover the price of a sea-front apartment in Monaco or Cristiano Ronaldos wages for a year. But it would not stretch to acquiring a Premier League footballer like Sergio Aguero or Samir Nasri.

The truth is that 25m does not go very far. That, however, is roughly how much the Finanzagentur reckoned it saved the German taxpayer when it grasped the opportunity to launch its $4bn benchmark in September 2009, its second foreign currency bond since the Second World War.

They would never say so on the record. But in private, bankers concede that in the context of its 334bn funding programme in 2009, the $4bn transaction probably generated more excitement in the media than it did at the Finanzagentur itself.

True, delivering 25m of savings to the taxpayer is clearly better than nothing, especially for a borrower that has made it abundantly plain that its only reason for exploring opportunities outside its home currency is arbitrage. Bankers point out that similar savings could be made, today, by a handful of other sovereign borrowers in the Eurozone that remain relatively uncontaminated by the crisis in southern Europe.

The Dutch State Treasury Agency (DSTA) has long been recognised as the most compelling example of a Eurozone sovereign that would probably be swamped with demand for a 144A transaction. Granted, its debt to GDP ratio has now crept up to 66%, its highest level since 1997. But that is still within the Maastricht guidelines (remember them?) and well below Germanys, which remains above 80%.

"The Netherlands could probably save 20bp or 30bp over its domestic curve if it issued in the dollar market," says Damian Carde, head of the EMEA frequent borrower group at RBS in London. Others agree. Citigroups head of public sector debt, Philip Brown, says that the tailwinds of a favourable basis swap would probably allow the DSTA to issue five year dollars at more than 50bp through its domestic DSL market on an after-swap basis. Austria, says Brown, is another example of a European sovereign that could achieve outstanding arbitrage in the dollar market today.

Carde says that this begs the obvious question of why some of the stronger Eurozone sovereigns have not issued more in the dollar market than they have. In the case of the Netherlands, it is certainly not for want of preparation. The DSTAs website features a very thorough 49-page presentation entitled "USD Dutch State Bond".

Volatility blocks progress

To Nathaniel Timbrell-Whittle, co-head of European SSA debt capital markets at BNP Paribas, in 2011 it has been intense volatility that has kept Eurozone sovereigns away from the dollar market. "At the end of 2010 it seemed that more European sovereigns were looking very closely at the US dollar market in an attempt to take advantage of the attractive basis swap," he says. "With GSE issuance declining and demand from central banks for triple-A paper offering a pick-up over Treasuries strong, all the necessary dynamics were in place. But most borrowers have felt that this years volatility has made the execution risk too high."

For the DSTA, that execution risk is heightened by the borrowers commitment to using the Dutch Direct Auction (DDA) mechanism to sell a dollar benchmark, a technique that was not built to withstand the sort of volatility that has characterised markets recently.

"Its true that the DDA is a more time-consuming process than a conventional syndication," says Peter Nijsse, head of cash management, issuance and trading at the DSTA. "To start a process like that we would need to be absolutely certain that if the market were to move against us we would still be able to make an adequate saving versus our euro curve." This, Nijsse adds, is especially important in a debut dollar transaction in which it would be essential to demonstrate the validity of the deals economics to parliament.

This hints at another reason why, even if the arbitrage of dollar issuance were to stack up favourably, modest short term savings for the taxpayer may not always be enough to outweigh other less quantifiable considerations.

The most topical of these is that for a Eurozone borrower to unveil a dollar benchmark at a time when the euro project is facing the most serious existential crisis of its short life, would risk being interpreted as an appalling betrayal.

Even at a less delicate time, say bankers, sovereign borrowers need to look carefully at how benchmark issuance outside their home market is likely to be interpreted, both by domestic and international investors. "When working on Germanys dollar benchmark, a major discussion point was the message that the Finanzagentur was giving to the market," says Ralph Berlowitz, managing director and European head of rates syndicate at Deutsche Bank.

"It is essential not to send the signal that youre unable to get your entire programme done in the domestic market. This is why it was so important for Germany to make it clear that its dollar issue was purely an opportunistic exercise, rather than one that was intended to take any pressure off its euro auctions."

The DSTA is addressing this pitfall by emphasising that whatever it chooses to do in the dollar market, there will be no impact on its euro funding programme. "We have always made it clear that if we issue in dollars it will be to reduce our outstanding debt in money market instruments," says Nijsse. "We want to remain predictable and transparent in the euro market and make sure there is no change to the announced size of our programme even if we do issue in dollars."

Bankers agree that the Netherlands is under no pressure to race into a dollar benchmark. "The DSTA has adequate access to the euro market, and US investors have plenty of exposure to the Netherlands in triple-A format via agencies such as BNG and NWB," says Jeremy Shaw, co-head of rates syndicate at Barclays Capital.

Patience needed

Other strong Eurozone credits considering issuing in dollars can afford to bide their time and make certain that any new issue broadcasts the right investor relations message. One banker points to Austria as an example. "Austria would love to use the dollar market as a way of reminding the market of the days when it traded at 10bp over Bunds," says one banker. "Austria believes that the market is wrong to price it where it does in euros and would love to use the dollar market to say, I told you so."

Martha Oberndorfer, managing director of the Austrian Federal Funding Agency, wont be drawn on precisely where Austria should be pricing in dollars. But she confirms that it can pick and choose its moment outside the domestic market. "Our investor base outside the Eurozone is slightly below 15%," she says. "Since we dont want to extend the overseas share north of 15%, we have to be very selective."

While it is critical for sovereigns not to suggest to investors that there is any pressure on their domestic funding programme, some issuers believe it is also imperative for sovereigns using the dollar market to show some degree of commitment to the investor base. At RBS, Carde says that this may explain why (aside from the Netherlands) France is the only major Eurozone sovereign that has eschewed dollar issuance to date. "I dont think France wants to be regarded as a one-off issuer," he says.

Fine. But where is the line to be drawn between being seen as an opportunistic and a strategic, regular borrower? In todays fragile market environment, the challenge facing many borrowers is to strike a balance between minimising execution risk and simultaneously providing sufficient liquidity.

"Guarding against execution risk is extremely important," says Bill Northfield, head of SSA origination at Deutsche Bank. "This is one reason why earlier this year we began recommending some issuers not to become fixated on a size of $2bn or $5bn as minimum notionals to attain benchmark status. Investors these days are far more concerned about deals being right-sized to suit the prevailing demand."

Citis Brown agrees. "Theres no longer much prowess in size," he says. "More than anything, investors want to be confident that a deal is over-subscribed and well placed. So as and when the market stabilises we would probably encourage Italy to think about smaller issue sizes in the dollar market."

Unmatched attractions

Clearly, it will be a while before the dollar market is ready to accommodate peripheral Eurozone borrowers. But bankers say that dollars remain open and highly receptive to a wide range of sovereign borrowers, and continues to offer those borrowers a number of attractions unmatched by any other currency.

"The dollar market has been and remains a very liquid market. It has proven to be consistent in tough times, especially for emerging market borrowers, and is the most developed market for sovereign borrowers," says Ulrik Ross, global head of public sector, global markets, at HSBC in London.

For many of those borrowers with large annual funding programmes, says Ross, the principal attraction of the dollar market is the opportunity it provides to diversify the investor base in a cost-effective way. Perhaps the most striking recent evidence was provided by Poland, which in October returned to the dollar market with a $2bn transaction via Citi, Deutsche and HSBC. Poland priced its 10 year benchmark at the tight end of guidance at 280bp, which represented a new issue premium of just 10bp, and generated an order book of $8bn.

Anna Suszynska, deputy head of public debt at the Polish Ministry of Finance, describes the 10 year maturity of the dollar market as the sweet spot for Poland, allowing it to cater to investor demand across the maturity spectrum. The relatively long maturity of Octobers issue certainly meant that Poland was able to access a more granular range of investors than most sovereigns. Some 76% of the issue was placed with fund managers, 10% with insurance companies and 4% with central banks, says Suszysnka. She adds that she was delighted with the strength of demand from US accounts, which took 60%.

Bankers say there is a very obvious logic for a non-Eurozone borrower like Poland to keep its options open in dollars as well as euros. Jonathan Brown, head of bond syndicate, Europe at Barclays Capital, says that although the zloty market accounts for about 80% of Polands annual funding, this is a limited and highly domestic-oriented investor base. "For Poland and a number of central and eastern European borrowers it makes sense to maintain access to the liquid dollar market, especially a time when the euro market is closed or congested," he says.

The placement of Polands October dollar benchmark is in contrast with the distribution patterns for most European sovereigns. Witness the example of Sweden, which launched its inaugural 144A transaction via Deutsche and RBS in May, accessing dollars to on-lend to the Riksbank for foreign exchange reserve purposes. Exploiting its scarcity value, its distance from the euro crisis and its safe-haven credentials to the full, Sweden priced its $1.5bn three year issue at mid-swaps less 10bp, or 18.75bp over the Treasury curve.

Some 74% of Swedens 144A deal was sold to central banks, which was broadly in line with the expectations of the Swedish National Debt Office, according to its head of funding, Maria Norström. "As it was our first 144A deal, we did attract some new US investors but to quite a limited extent," she says. "That was not a reflection of their view of the Swedish credit, but a pricing issue. There are other safe haven assets they can buy in US dollars from supranationals and agencies, for example, offering more of a pick-up over Treasuries. The bulk of our 144A demand came from central banks driven principally by capital preservation motives."